The state of the public finances and the need to cut public borrowing were, quite rightly, the issues which dominated the political conference season this year. Whatever the country’s other problems, and there are many, the burgeoning sea of red ink in the Treasury’s books should concern us all. In his April budget, the Chancellor forecast borrowing of around £175 billion, equivalent to about 12 per cent of GDP, for this financial year and next. Borrowing was then expected to fall back, reflecting economic recovery. But the projected improvements in the figures should not remotely be interpreted as signalling a return to fiscal normality or sustainability. Very hard decisions will have to be made if the public finances are to be rectified.
The still-influential credit rating agencies usually become nervous about maintaining a sovereign borrower’s ‘Triple-A’ status if public debt as a proportion of GDP rises above 70 per cent or so. On the government’s own definition of ‘net public debt’, this ratio is expected to creep above the critical level by the end of 2011/12, and to continue increasing. If GDP growth were to fall short of the Chancellor’s budget forecasts — in which growth rates of more than 3 per cent were assumed from 2011/12 — the surge in public debt would inevitably become even more problematic. And there are, worryingly, at least two reasons to expect that GDP growth will be relatively anaemic over the next few years. First, bank lending is likely to be restricted, restraining economic recovery; and second, the underlying trend rate of growth may be lower than in the recent past as a consequence of the damage the economy suffered during the downswing.
Under these circumstances a future government could well be faced with the prospect of losing the UK’s Triple-A rating. Earlier this year one rating agency, Standard and Poor’s, issued a warning about our public finances. Even though they confirmed the Triple-A status at the time, they revised Britain’s sovereign debt outlook from ‘stable’ to ‘negative’ and threatened a downgrade if they concluded that, following the election, the next government’s fiscal consolidation plans were unlikely ‘to put the UK debt burden on a secure downward trajectory over the medium term’. In other words, Britain was on probation. Cut the deficits — or else.
Losing Triple-A status would matter. It would almost certainly push up the cost of servicing the debt. Increased debt interest payments would, in turn, add to public deficits and debt — a vicious circle. Even without the extra servicing costs arising from a loss of credit status, debt interest payments are now growing as fast as public-sector debt balloons. On the Treasury’s relatively optimistic projections, debt interest is expected to be £43 billion, some 8 per cent of current receipts, in 2010/11. That is greater than the defence budget.
But even if the credit agencies continue to give UK debt the top rating, markets may take a less benign view. The demand for government debt has been supported over the past six months by the Bank of England’s Asset Purchase Facility (otherwise known as quantitative easing), under which the Bank has overwhelmingly bought gilts. This programme will, we must assume, end before long. And it will be at this point that the true market demand for gilts will be tested. Let’s hope the appetite for buying gilts does not become sated — but this cannot be guaranteed and a replay of the 1976 IMF bailout cannot be ruled out.
So the deficit must be cut — and the cuts will have to be painful and deep. The shadow chancellor is to be congratulated for his tough stance at the party conference. Public sector pay freezes, welfare reforms and reviews of the state pension age and public-sector pensions are all long overdue, and will need to be part of a comprehensive fiscal consolidation package.
But such reforms will not only be needed for plugging the hole in the public finances in the short to medium-term; they will also be required as a longer-term response to the potentially exploding fiscal costs of Britain’s ageing population. Owing to a combination of increased longevity and non-replacement (though rising) fertility rates, the population aged 65 and over is increasing as a percentage of the total. In 1970, the ratio was just 13 per cent. By 2010 it is expected to be around 16.5 per cent and by 2050, nearly 23 per cent. (Incidentally, these demographic trends are expected in much of the developed world and China; the situation is even more acute in Japan, where more than one in three will be 65 or over by 2050.)
These changed demographics will have a profound influence on people’s working lives and major implications for the way in which costs associated with the elderly — pensions, healthcare and long-term care — are to be funded if they are not to place intolerable burdens on future generations of taxpayers.
The European Commission’s Economic and Financial Affairs directorate-general recently released its Sustainability Report 2009, which allowed for the impact on the public finances of the rising costs associated with ageing populations, as well as assessing the current budgetary position. The report concluded that, on unchanged policies, Britain was, somewhat ignominiously, in the ‘sin bin’ of high-risk countries with regard to the long-term sustainability of its public finances, along with Ireland, Greece, Spain and Slovenia. Public sector debt as a percentage of GDP could rise to 160 per cent by 2020, 400 per cent by 2040 and 760 per cent by 2060. Although the contribution to the public debt of the effects of an ageing population in Britain ‘was not the most problematic in the EU’, it was nevertheless significant and this, combined with the highly disadvantageous initial budgetary position, sealed Britain’s position in the humiliating high-risk category.
Needless to say, the commission’s figures were greeted by howls of denial from the Treasury, which claimed that its projections ‘had no basis in reality’. And I have little doubt that they will never be actualised — policies would simply have to change rather than allow the build-up of such colossal levels of debt. But the projections bring home some very painful truths that are arguably even more painful than the truths we are already coming to grips with. Not only will future chancellors have to deal with the horrendous budget deficits currently experienced, but they will also have to start instituting major changes to the way pensions, healthcare and long-term care are funded over the next 20 to 30 years.
On both these counts, it can fairly be said that the current government has failed lamentably as custodian of the country’s finances and future. Gordon Brown inherited a golden legacy from the Conservatives, but his reckless spending spree was a train crash waiting to happen and is directly responsible for the current fiscal wreckage. Worse in some ways, though not so frequently commented upon, has been the government’s refusal to take difficult decisions about the funding of public sector pensions and the NHS in order to prepare the country for the next five decades. Public sector pensions, where the total unfunded liability probably exceeds £1 trillion, are especially problematic. Britain has a government driven by vote-winning gimmickry, deliberately shirking difficult but vital decision-making.
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